RISK MANAGEMENT

In Banks

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 WHAT IS BANK’S BUSINESS?
 Borrowing
 Investing
 Lending
 Intermediary

Bank earns on taking ‘risk’

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 Peculiarity of bank business

 Banking is risky business

 Very high leverage
India – Food 1.1, Machinery 0.6,Automobiles 1.1, Telecom 0.4,
Banking 17.6
US – Manufacturing 0.2 – 0.3, Utilities 1.3, Trading 0.3, Banking 15
 Opaque assets – loans, derivatives, non-transparent OTC trading
 Moral hazard – deposit insurance

Banking is a disaster prone industry

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 Understanding bank’s business
Bank’s liabilities
 Capital
 Reserves and surplus
 Deposits
 Borrowings
 Other liabilities and provisions
 Contingent liabilities

No default of deposits, borrowings…

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 Understanding bank’s business

Bank’s Assets:
 Cash and balances with RBI
 Balances with banks and money at call and short notice
 Investments
 Advances
 Fixed assets
 Other assets

Assets quality very dynamic and can deteriorate fast

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 Understanding bank’s business

Bank’s profit and loss account:

 Income –
Interest and other income
 Expenses –
Interest
Operating
Provisions and contingencies

Fixed, Semi-variable and Variable – Appropriate Mix

important
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 What is Risk
 Risk concerns the deviation of one or more
results of one or more future events from
their expected value.

 Financial risk is defined as the unexpected

variability or volatility of returns and thus
includes both potential worse-than-expected
as well as better-than-expected returns.
 Various Types of Risks:
Capital Retail Asset Insurance
Markets Banking Management

Key Risk Components

Strategic
Market Risk Operational Insurance Business
Credit Risk
Risk Risk Risk

Risk Adjusted
Performance Capital Risk Shareholder
Measurement Allocation Management Value Added
 Contd
 All investments have an inherent risk.

 For a bond, for example, there are the following risks:

 The risk that the bond will default;
 The risk that the bond will devalue, e.g. due to IR
changes;
 Other risks, such as the computer system failing when
you receive payment from the bond at maturity.

 These risks can be quantified using several methods.

There are also international regulations (e.g. Basel2) that
limit the risk banks can take.
 Types of banking risks

 Financial (credit, liquidity, market)

 Operating (IT failures, damage to physical assets, frauds)
 Business (Strategic, reputation, compliance, legal, country)
 Event (Political, banking or systemic crisis)

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 Market Risk
Market risk is the risk that the value of a portfolio,
either an investment portfolio or a trading portfolio,
will decrease due to the change in value of the
market risk factors.

 Trading and Market risk

 Exposure of a institution’s financial condition to
adverse movements of market parameters (rates…).
 The most developed area of risk management, but
institutions are still investing in this area.
 Types of Market Risks
The four standard market risk factors are:

1)Equity Risk: Equity risk is the risk that one's investments will
depreciate because of stock market dynamics causing one to lose
money.

2)Interest Rate Risk: Interest rate risk is the risk that interest rates and/or
the implied volatility will change.

3)Foreign Exchange Risk: Currency risk is a form of risk that arises

from the change in price of one currency against another.

4)Commodity Risk: Commodity risk is the risk that commodity prices

(e.g. corn, copper, crude oil) and/or implied volatility will change.
 Credit Risk
 Credit risk is an investor's risk of loss arising from a borrower
who does not make payments as promised. Such an event is
called a default. Another term for credit risk is default risk.

 Credit risk

 Risk that losses are incurs if a customer does not fulfil its
financial obligations.

 This is the major focus of regulatory attention and is heavily

featured in Basel2 proposals.

 With the trend to consolidation and globalisation, firm-wide

credit risk management becomes both harder and more
important.
 Operational Risk
 "The risk of loss resulting from inadequate or failed
internal processes, people and systems or from external
events.“

 Operational risk

 Exposure created by deficiencies of IT, processes and

controls that may result in unexpected losses.
 This is another area of increased regulatory attention.
 Operational Risks can arise due to:
 Internal Fraud
 External Fraud
 Employment Practices and Workplace Safety
 Clients, Products, & Business Practice
 Damage to Physical Assets
 Business Disruption & Systems Failures
 Execution, Delivery, & Process Management
 Operational Risk Losses Types
1. Legal Liability:
inludes client, employee and other third party law suits
2 . Regulatory, Compliance and Taxation Penalties:
fines, or the cost of any other penalties, such as license revocations and
associated costs - excludes lost / forgone revenue.
3 . Loss of or Damage to Assets:
reduction in value of the firm’s non-financial asset and property
4 . Client Restitution:
includes restitution payments (principal and/or interest) or other
compensation to clients.
5 . Theft, Fraud and Unauthorized Activities:
includes rogue trading
6. Transaction Processing Risk:
includes failed or late settlement, wrong amount or wrong counterparty
 What is Risk Management?
 Risk management is the identification, assessment, and
prioritization of risks followed by coordinated and
economical application of resources to minimize, monitor,
and control the probability and/or impact of unfortunate
events.

 The strategies to manage risk include transferring the risk

to another party, avoiding the risk, reducing the negative
effect of the risk, and accepting some or all of the
consequences of a particular risk
Market Risk Mitigation(Interest Risk

 Interest Rate Risk can be handled with the

help of Interest rate Swaps.
 Functioning of Interest Rate Swap
 Party A agrees to pay Party B periodic fixed interest rate
payments of 8.65%, in exchange for periodic variable
interest rate payments of LIBOR + 70 bps (0.70%).

 Note that there is no exchange of the principal amounts

and that the interest rates are on a "notional" (i.e.
imaginary) principal amount.

 Also note that the interest payments are settled in net

(e.g. Party A pays (LIBOR + 1.50%)+8.65% -
(LIBOR+0.70%) = 9.45% net. The fixed rate (8.65% in
this example) is referred to as the swap rate.
 Market Risk Mitigation( Currency
Risk)
1) Hedging using Currency Options: In finance, a
foreign exchange option (commonly shortened
to just FX option or currency option) is a
derivative financial instrument where the owner
has the right but not the obligation to exchange
money denominated in one currency into
another currency at a pre-agreed exchange rate
on a specified date.
 Continue
Hedging Using Currency Future:Investors use futures
contracts to hedge against foreign exchange risk. If an investor will
receive a cashflow denominated in a foreign currency on some future
date, that investor can lock in the current exchange rate by entering
into an offsetting currency futures position that expires on the date of
the cashflow.

Example:Jane is a US-based investor who will receive €1,000,000 on

December 1. The current exchange rate implied by the futures is
$1.2/€. She can lock in this exchange rate by selling €1,000,000 worth
of futures contracts expiring on December 1. That way, she is
guaranteed an exchange rate of $1.2/€ regardless of exchange rate
fluctuations in the meantime.
 Continue
3)Hedging using Currency Swaps: A
currency swap is a foreign-exchange agreement
between two parties to exchange aspects (namely
the principal and/or interest payments) of a loan in
one currency for equivalent aspects of an equal in
net present value loan in another currency.
 Mitigating Credit Risk
 Tools to mitigate credit risk:

1)Risk Based Pricing:Lenders generally charge a higher interest rate to

borrowers who are more likely to default.
2) Covenants: Lenders may write stipulations on the borrower, called
covenants, into loan agreements.
3) Credit insurance and credit derivatives:These contracts the transfer risk
from the lender to the seller (insurer) in exchange for payment.
4) Diversification: Lenders reduce this risk by diversifying the borrower
pool.
5) Deposit insurance: Takes guarantee against the loan.
 ASSET LIABILITY
MANAGEMENT
 In banking, asset and liability
management is the practice of managing
risks that arise due to mismatches between
the assets and liabilities (debts and assets)
of the bank. This can also be seen in
insurance.
 ASSET LIABILITY
MANAGEMENT PROCESS
The scope of ALM function can be described as follows:

 Liquidity risk management

 Management of market risks

 Funding and capital planning

 Profit planning and growth projection

 Trading risk management

 The guidelines given in this note mainly address liquidity and Interest Rate
risks
 The ALM process rests on three
pillars:
 ALM information systems
=> Management Information System
=> Information availability, accuracy, adequacy and expediency

 ALM organisation
=> Structure and responsibilities
=> Level of top management involvement

 ALM process
=> Risk parameters
=> Risk identification
=> Risk measurement
=> Risk management
=> Risk policies and tolerance levels.
 Purpose & Objective of ALM
An effective Asset Liability Management Technique aims to manage the
volume, mix, maturity, rate sensitivity, quality and liquidity of assets
and liabilities as a whole so as to attain a predetermined acceptable
risk/reward ration.
It is aimed to stabilize short-term profits, long-term earnings and long-
term substance of the bank. The parameters for stabilizing ALM
system are:

1. Net Interest Income (NII)

2. Net Interest Margin (NIM)
3. Economic Equity Ratio
 Liquidity Management

Bank’s liquidity management is the process of

generating funds to meet contractual or
relationship obligations at reasonable prices
at all times.
New loan demands, existing commitments,
and deposit withdrawals are the basic
contractual or relationship obligations that a
bank must meet.
 Adequacy of liquidity position for a
bank
Analysis of following factors throw light on a bank’s adequacy of
liquidity position:

a. Historical Funding requirement

b. Current liquidity position
c. Anticipated future funding needs
d. Sources of funds
e. Options for reducing funding needs
f. Present and anticipated asset quality
g. Present and future earning capacity and
h. Present and planned capital position
 Types of Liquidity Risk
 Liquidity Exposure can stem from both internally and
externally.

 External liquidity risks can be geographic, systemic or

instrument specific.

 Internal liquidity risk relates largely to perceptions of

an institution in its various markets: local, regional,
national or international
Statement of Structural Liquidity
 All Assets & Liabilities to be reported as per their
maturity profile into 8 maturity Buckets:1 to 14 days
 15 to 28 days
 29 days and up to 3 months
 Over 3 months and up to 6 months
 Over 6 months and up to 1 year
 Over 1 year and up to 3 years
 Over 3 years and up to 5 years
 Over 5 years
 STATEMENT OF
STRUCTURAL LIQUIDITY
 Places all cash inflows and outflows in the maturity ladder as per
residual maturity

 Maturing Liability: cash outflow

 Maturing Assets : Cash Inflow

 Classified in to 8 time buckets

 Mismatches in the first two buckets not to exceed 20% of outflows

 Shows the structure as of a particular date

 Banks can fix higher tolerance level for other maturity buckets.
 An Example of Structural Liquidity
Statement
15-28 30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5
1-14Days Days 3 Month 6 Mths 1Year Years 5 Years Years Total

Capital 200 200

Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0
Gap % to Total Outflow
-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57
 ADDRESSING THE
MISMATCHES
 Mismatches can be positive or negative

 Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.

 In case of +ve mismatch, excess liquidity can be deployed in money

market instruments, creating new assets & investment swaps etc.

 For –ve mismatch,it can be financed from market borrowings

(Call/Term), Bills rediscounting, Repos & deployment of foreign
currency converted into rupee.
 STRATEGIES…
 To meet the mismatch in any maturity bucket, the
bank has to look into taking deposit and invest it
suitably so as to mature in time bucket with
negative mismatch.

 The bank can raise fresh deposits of Rs 300 crore

over 5 years maturities and invest it in securities
of 1-29 days of Rs 200 crores and rest matching
with other out flows.
 Maturity Pattern of Assets & Liabilities of A Bank
Liability/Assets Rupees In Percentage
(In Cr)

I. Deposits 15200 100

a. Up to 1 year 8000 52.63
b. Over 1 yr to 3 yrs 6700 44.08
c. Over 3 yrs to 5 yrs 230 1.51
d. Over 5 years 270 1.78
II. Borrowings 450 100
a. Up to 1 year 180 40.00
b. Over 1 yr to 3 yrs 00 0.00
c. Over 3 yrs to 5 yrs 150 33.33
d. Over 5 years 120 26.67
III. Loans & Advances 8800 100
a. Up to 1 year 3400 38.64
b. Over 1 yr to 3 yrs 3000 34.09
c. Over 3 yrs to 5 yrs 400 4.55
d. Over 5 years 2000 22.72
Iv. Investment 5800 100
a. Up to 1 year 1300 22.41
b. Over 1 yr to 3 yrs 300 5.17
c. Over 3 yrs to 5 yrs 900 15.52
d. Over 5 years 3300 56.90
 MATURITY GAP METHOD
(IRS)
 THREE OPTIONS:
 A) RSA>RSL= Positive Gap
 B) RSL>RSA= Negative Gap
 C) RSL=RSA= Zero Gap
 Interest Rate Risk Management
 Interest Rate risk is the exposure of a bank’s financial
conditions to adverse movements of interest rates.

 Though this is normal part of banking business,

excessive interest rate risk can pose a significant threat
to a bank’s earnings and capital base.

 Changes in interest rates also affect the underlying

value of the bank’s assets, liabilities and off-balance-
sheet item.
 Interest Rate Risk
 Interest rate risk refers to volatility in Net
Interest Income (NII) or variations in Net
Interest Margin(NIM).

 Therefore, an effective risk management

process that maintains interest rate risk
within prudent levels is essential to safety
and soundness of the bank.